NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-6
Session-12
Valuation of Equity Shares II
Outline
Cash flow based valuation
Dividend Discount Model
FCFF
FCFE
Valuation in special cases

Cash flow based valuation: Cash is King. A companys value is driven by its ability to generate cash
flow over the long term (Copeland et al, 2000). Since the investors invest primarily cash in an
enterprise, there are expectations that the enterprise generates cash flow for future growth and
returning back to the investors. Since the cash flows occur at different points of time, one need to
bring the cash flow to present value. That is why the cash flow based valuation is known as
discounted cash flow approach. Different cash flow based valuation methods / models are discussed
subsequently.
Dividend Discount Model (DDM): This model is applied to value equity. Dividend is the
distribution of profit to the equity holders. Dividends can be distributed in terms of cash or shares i.e.
bonus shares. DDM considers cash distributed as dividend. Firms are expected to declare dividend
with the help of cash flow generated in normal course of business. Investors like pensioners look at
dividend as a regular source of income and may not be bothered about change in market price as long
as dividends remain stable. Similarly institutional investors like pension funds favour equity shares
such companies that declare good amount of dividend. In DDM, the expected dividends of company
are discounted to present to find the value of an equity share. The generic version of the model is as
below:

P0 =

D1
D2
D3
D
+
+
+ ......
2
3
(1 + ke) (1 + ke) (1 + ke)
(1 + ke)

Where, P0 is the price of equity share today and D1, D2 are the expected dividend per share (DPS)
for year 1, 2 and like. ke is the expected rate of return of equity investors.
No Growth or zero growth model: If expected DPS remains same for all the years to come [i.e. D1, =
D2 = D3, .] the above model can be approximated as below:

P0 =

D
ke

Suppose the dividend and ke are Rs.4 and 12% respectively, then P0 = Rs.4/0.15 = Rs.26.67

Constant Growth in Dividend: If the dividend is expected to grow at a constant rate for all the time to
come, then the DDM approximates as below:

P0 =

D1
ke - g

Example: Present dividend per share (D0) is Rs.4 and is expected to grow at 6% per annum till
perpetuity and cost of equity of 12%.
First we need to estimate D1.
D1 = Rs.4*(1+0.06) = Rs.4.24
Then P0 = Rs.4.24/(0.12-0.06)=Rs.70.67
Multi Stage Growth Model (variable growth model): It is unlikely that dividends will grow at a
constant rate. Dividends might grow at higher rate in the initial years known as super normal growth
period and then grow at constant rate, which is termed as stable stage growth. In such case, one has to
estimate the dividends for different years of super normal or high growth period separately and
discount them to present value and then bring the value of stable stage dividend to present value
separately.
Example: Multi Stage Growth
D0 = Rs.4
Dividend is expected to grow at 12% for next three year and then at 10% for subsequent 2 two years
after which the growth will stabilize at 8%. If the cost of equity is 15%, what is the value per share?
Example: Multi Stage Growth, contd..
Step I: One has to estimate the dividends for year 1 through 6:
D1 = Rs.4.00*(1.12)=Rs.4.48
D2 = Rs.4.00*(1.12)2=Rs.5.02
D3 = Rs.4.00*(1.12)3=Rs.5.62
D4= Rs.5.62*(1.10)=Rs.6.18
D5= Rs.6.18*(1.10)=R.6.80
D6= Rs.6.80*(1.08)=Rs.7.34
Step II: Find the terminal value at the end of 5th year after which constant growth starts.
TV5 = D6/(ke-g) = Rs.7.34 / (0.15-0.08)=Rs.104.91
Step III: Discount the individual dividends from year 1 to 5 as well as TV5 to present value and sum
all the values to find the value per share:

P0 =

4.48
5.02
5.62
6.18
6.80
104.91
+
+
+
+
+
= Rs.70.46
2
3
4
5
1.15 (1.15)
(1.15) 5
(1.15)
(1.15)
(1.15)

Free Cash Flow Approaches: Free cash flow is the cash flow available after meeting all the claims. It
can be free cash flow to firm, FCFF (i.e. from all stake holders point of view) or free cash flow to
equity, FCFE (from equity holders point of view). By using FCFF, the value of company can be
found and from that valuation of equity can be derived. By using FCFE, the value of equity can
directly be found out.
Firm Valuation
The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash
flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted
average cost of capital, which is the cost of the different components of financing used by the firm,
weighted by their market value proportions.
t =n

Value of Firm =
t =1

CF to Firm t
(1 + WACC) t

Where,
CF to Firmt = Expected Cash flow to Firm in period t
WACC = Weighted Average Cost of Capital
Value of Equity
= Value of firm Value of Preference Share Capital (if any) Value of Debt
Equity Valuation: The value of equity is obtained by discounting expected cash flows to equity, i.e.,
the residual cash flows after meeting all expenses, tax obligations and interest and principal
payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm.
t =n

CF to Equity t
(1 + k e ) t
t =1

Value of Equity =
Where,

CF to Equityt = Expected Cash flow to Equity in period t

ke = Cost of Equity
Key Ingredients for FCF Approach

Discount rate
Cost of equity
Cost of capital (WACC) [it considers the cost of capital for all components of capital
like equity capital, preference share capital, debt etc.]
Estimation of cash flows
Estimation of operating income
Estimation of tax rate
Estimation of capital expenditure and net working capital
Estimation of growth rate in cash flows
Growth rate = Reinvestment rate x return on capital

Other considerations like non-operating assets, excess cash

Generic Model for FCFF

In general, FCFF = EBIT (1-t) + Depreciation - Capital Expenditures - Change in Non-cash WC
Example for FCFF valuation model 1
The following valuation example relates to a hypothetical firm engaged in manufacturing of drugs and
pharmaceuticals. It is expected to grow at a super normal growth rate for the next three years after
which it is expected to have normal growth, constant over its life. The reinvestment rate is based on
capital expenditure, change in working capital and net of depreciation for a given year.

Year
Growth rate
NOPAT [EBIT (1-t)]
Reinvestment Rate [% of NOPAT]
Cost of Equity
Cost of Debt [pre-tax]
Debt Ratio
Cost of Capital (WACC)
Return on Capital
Tax rate

0
100

1
22.50%
122.50
75%
16.00%
8%
20%
13.76%
30%

2
22.50%
150.06
75%
16.00%
8%
20%
13.76%
30%

3
22.50%
183.83
75%
16.00%
8%
30%
12.64%
30%

Rs. Crore
4
4.80%
192.65
40%
12.00%
7%
40%
8.88%
12%

30.63

37.52

45.96

115.59

26.92

28.99

2833.09
2014.52

40%

FCFF
Terminal Value
[FCFF from 4th year onwards]
PV of FCFF and Terminal Value
Value of operating assets
Non-operating assets [given]
Value of the firm
Market value of debt [given]
Value of equity

2070.43
120.00
2190.43
300.00
1890.43

Other Approaches for Valuation

Private Equity Approach: Private equity players typically invest in high expected return, high growth
potential, thus high risk companies. They apply a higher discount rate for valuation.
Valuation for Mergers and Acquisitions: To the value of equity determined by different approaches, a
control premium is added to find the value of equity stake in the company.
*******

Adapted from Damodaran, A (2006), Damodaran on Valuation Security Analysis for Investment and
Corporate Finance, Wiley and Sons.

References:
Copeland, Tom, Koller, T & Murrin, J (2000), Valuation Measuring and Managing the Value of
Companies, 3e, John Wiley & Sons
Damodaran, Aswath (2007), Corporate Finance Theory and Practice, 2e, Wiley India
Damodaran, A (2006), Damodaran on Valuation Security Analysis for Investment and Corporate
Finance, Wiley and Sons.
Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson (Cengage)
Learning, New Delhi
Bodie et al (2009), Investments, 8e, Tata McGraw Hill, New Delhi
Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata McGraw Hill,
New Delhi

Questions and Answers

Q.1: Ken Limited has just declared Rs.6.00 as dividend per share (DPS). The beta of Kens stock is
0.8. The market rate of return and risk free rate of return are 14% and 7% respectively.
a) If the DPS of Ken Limited is expected to remain constant, what is the value of share?
b) If the DPS is expected to grow @6% per annum constantly, what is the value per share?
Ans.:
Applying capital asset pricing model,
The expected rate of return = ke = Rf + *(Rm Rf) = 0.07 + 0.8 * (0.14 0.07) = 0.126 = 12.6%
a) Value per share = DPS / ke = Rs.6.00 / 0.126 = Rs.47.62
b) DPS1 = DPS0 * (1 + g) = Rs.6.00 * 1.08 = Rs.6.48
Value per share = DPS1 / (ke g) = Rs.6.48 / (0.126 0.06) = Rs.98.18
Q.2: Zairo Limited has just declared Rs.5.00 as dividend per share. This is expected to grow at 15%
for the next three years, then @ 10% for subsequent 2 years and further @ 6% constantly per annum
from 6th year onwards. If ones expected rate of return is 14%, how much one should pay for buying
the share?
Ans.: This is a multi-stage dividend model.
Expected dividend per share by taking the appropriate growth rates:
Year:
DPS (in Rs.)
Present value of DPS @
14% (in Rs.)

0
5.0000

1
5.7500
5.0439

2
6.6125
5.0881

3
7.6044
5.1327

4
8.3648
4.9526

5
9.2013
4.7789

6
9.7534

Present value of Dividends 1 through 5 = Rs. 24.9962

Terminal value at the end of year 5 = DPS6 / (ke g) = Rs.9.7534 / (0.14 0.06) = Rs.121.9171
Present value of terminal value = Rs.121.9171 / (1 + ke)5 = Rs.63.3199
Value per share = Rs.24.9962 + Rs.63.3199 = Rs.88.62

Q.3: Find the value of XYZ Cos equity share by using free cash flow to firm (FCFF) approach with
the help of following information.
SOURCES OF FUNDS
Shareholders funds
Equity share capital (12
crore shares of Rs.10
each)
Reserves and Surplus
10% Loan

2009-10 APPLICATION OF FUNDS

Gross fixed assets
120 Less: accumulated depreciation

280 Net fixed assets

600 Net working capital
1,000

2009-10
1,100
400

700
300
1,000

The EBIT of XYZ for 2009-10 is Rs.250 crore. Depreciation for the year is Rs. 70crore The company
is subject to 40% tax rate. The growth in sales, depreciation NOPAT (net operating profit after tax),
gross fixed assets and net working capital will be 18% for the first three years, 10% for the next two
years and 7% thereafter. There will be no change in the tax rate and present debt ratio. The expected
rate of return of equity shareholders is 16%.
Ans.: The net operating profit after tax for 2009-10 = EBIT * (1 tax rate) = Rs.250crore * (1 - 0.40)
= Rs.150crore.
Debt ratio = 0.60
Post tax cost of debt: 0.06
Weighted average cost of capital (k) = Wd * Kd + We * Ke = 0.60 * 0.06 + 0.40 * 0.16 = 0.10
Forecasted FCFF:
Year:
Growth rate (%)
Assets (end
value)
NOPAT
Depreciation
Increase in assets
FCFF
Discounted value
of FCFF (@10%)

2009-10

1,000
150.00
70.00

2010-11 2011-12 2012-13 2013-14 2014-15 2015-16

18%
18%
18%
10%
10%
7%
1180.00
177.00
82.60
180.00
79.60

1392.40
208.86
97.47
212.40
93.93

1643.03
246.45
115.01
250.63
110.84

1807.34
271.10
126.51
164.30
233.31

1988.07
298.21
139.16
180.73
256.64

2127.23
319.09
148.91
139.16
328.83

The terminal value of the firm = FCFF6 / (k g) = 323.83 / (0.10 0.07) = Rs.10,961 crore
Present value of FCFF from 2010-11 till 2014-15 = Rs.551.97 crore
Present value of terminal value = 10,961 / (1+.10)5 = Rs.6805.85 crore
Total value of the firm = Rs.7357.81 crore
Value of equity = Value of firm value of debt = Rs.7357.81 crore Rs.600 crore = Rs.6,757.81
crore
Value per share = Rs.6,757.81 crore / 12 crore= Rs.563.15